Thursday, May 15, 2014

Macro-economic volatility has
decreased substantially from the mid 80s onwards in a large number of
economies. This period of reduced macro volatility was termed the Great Moderation. However, during the financial
crisis GDP growth plummeted and inflation evaporated just to rebound thereafter
amid massive fiscal and monetary easing. This lead macro volatility higher and
stopped the talk of the Great Moderation. However, as of late volatility in a
large number of economic data – most notably growth and inflation – has
decreased again. This is shown in the chart below for US real GDP growth. There
are a number of reasons for a more stable growth development, most notably that
modern economies are far less dependent on the very cyclical and volatile
manufacturing sectors but more dependent on less cyclical and less correlated
services sectors (for example, education and healthcare). Moreover, inventory
management has also been a key factor in determining macro-economic
volatility. During good times,
manufacturers and retailers increase their inventories, thereby leading to even
higher growth. During bad times, though, they want to reduce inventories and as
a result, production needs to be decreased by more than demand has fallen,
aggravating the downturn. Nowadays, however, more manufacturers use just-in-time
management methods and are used to lean inventories. As a result, this also
reduces macro-economic volatility (and again services are less volatile as
services can not be stored and hence there is no inventory problem).
Additionally, the state has a larger role within the economy than during previous
periods and tends to act as an economic stabiliser. Finally, the monetary policy enviornment has changed as central banks increasingly focused on providing for a stable enviornment via the adoption of inflation targets. As central banks have become more credible in securing a low inflation
environment, inflation expectations
and therefore also inflation has become more stable (and inflation tends to be more stable at low levels anyhow).

US GDP and rolling standard deviation: increased stability after the Financial Crisis

Source: Bloomberg, ResearchAhead

These factors are all still in existence and hence this should be seen as the main reason why the environment of
low macro-economic volatility has re-established itself. What is more though, nowadays
there is one additional element at play as a means to prevent another financial
crisis: the increased usage of macro-prudential policies. The aim of such
policies is to manage systemic risks within the banking sector as well as the broader
economy. It thereby should lower the probability of another devastating
financial crisis. Mostly, it is expected to do this via preventing the build-up
of new excesses in certain regions or sectors. As an example, facing a
credit-fuelled house price surge, the macro-prudential regulator would for
example demand higher capital buffers or reduce the maximum allowed loan-to-value
ratio. This should ease rampant credit growth and should thereby stabilise the
housing market. For overall economic growth it
means that it should be somewhat lower than would otherwise be the case. Furthermore,
the central bank does not need to take care of regional or sectoral excesses. Combined
with a more subdued growth rebound it can refrain from hiking rates for longer.
Or put differently, the central bank does not need to raise rates in order to
break the neck of a housing boom (and thereby killing the economy) but can instead
focus on the overall economic developments. In this case, it should also take
longer for inflationary pressures to materialise amid an overall less
pronounced growth recovery. On the other side, if a downturn hits, it should
also be milder and shorter as the previous excesses were smaller and there are
more instruments available (easier capital rules, lending standards) to
counteract the downturn than was the case in earlier business cycles. As a result, the introduction
of macro-prudential policies should help to lower macro-economic volatility
further and serves as a partial substitute for traditional monetary policy.
This can be seen with the example of Switzerland. The Swiss National Bank
introduced a floor in the EURCHF rate in 2011 in order to prevent a strong
currency from driving the economy into a deflationary recession. However, doing
so meant giving up implementing an independent monetary policy. Effectively, the
SNB can not hike rates for as long as the ECB does not hike rates or it needs to give up on its exchange rate target. The
resulting loose monetary policy environment (zero rates and aggressive balance
sheet lengthening) provided fuel to an already existing housing market upturn.
In order to slow down the housing market, the Swiss government has – on the
request from the SNB – increased banks' counter-cyclical capital buffers for
mortgages for the second time in January this year. This measure should promote
a less loose environment in the mortgage market while at the same time allows
the SNB to conduct its easy monetary policy for the broader economy for longer.

For
markets, the lower macro-economic volatility should be mirrored in lower
financial market volatility across asset classes. Moreover, the volatility of central bank rates
should drop even more as in those currency areas where macro-prudential
policies play a more important role, policy rates need to be changed by less. This
also means that respective central banks can wait longer before they revert to
rate hikes.This all argues in favour of carry and of less liquid products across financial markets as well as for an environment of lower risk premia and flatter curves than at similar stages during previous business cycles.

Subscribe To

About Me

Daniel was Head of Economics & Strategy for developed markets at Dresdner Kleinwort until early 2009 and was responsible for the well-known 'Ahead of the Curve' flagship publication. He started as a Desk Analyst in the mid-90s for the former German government bond trading desk. He then became Head of Rates Strategy early last decade and later on also took responsibility for G10 economics, commodities strategy and asset allocation.
He is now the owner of Research Ahead GmbH located in Frankfurt am Main.

Disclaimer

The content on this site is provided as general information only and should not be taken as investment advice. All site content, including advertisements, shall not be construed as a recommendation to buy or sell any security or financial instrument, or to participate in any particular trading or investment strategy. The ideas expressed on this site are solely the opinions of the author(s) and do not necessarily represent the opinions of sponsors or firms affiliated with the author(s). The author may or may not have a position in any company or advertiser referenced above. Any action that you take as a result of information, analysis, or advertisement on this site is ultimately your responsibility. Consult your investment adviser before making any investment decisions.